Mr. Murray: – Good morning. I'm William Murray, Chief of Media Relations at the IMF. This is a live press conference on the IMF's latest GFSR. Joining me today is José Viñals, Financial Counselor and Director of the IMF's Monetary and Capital Markets Department, and Jose's colleagues in the Monetary and Capital Markets Department, Mr. Brockmeijer, Mr. Sheehy, and Mr. Dattels. José will have some brief opening remarks, and then we'll take your questions. I would also encourage those watching via the Online Media Briefing Center to submit their questions as soon as possible. And also remind our viewers outside of this room that this briefing is on the Global Financial Stability Report, and not on a host of other issues that we'll deal with over the course of the next week. Mr. Viñals.

Mr. Viñals: Thank you, Bill, and good morning. Three years have passed since the onset of the global financial crisis, and significant progress has been made in stabilizing the system, repairing balance sheets and strengthening policy frameworks. However, the key message of this Global Financial Stability Report is that the financial system remains the Achilles' heel of the economic recovery. Much work still needs to be done to ensure global financial stability. In what follows, let me first describe the outlook for financial stability and then go to describing the policies that we recommend.

Our outlook envisages a gradual improvement in financial stability as the ongoing economic recovery continues and policies aimed at strengthening the financial system are fully implemented. But, the outlook is subject to considerable downside risks linked to financial system fragilities and weak sovereign balance sheets.

Let me begin with the good news that progress is being made in strengthening the financial system. As will be detailed in tomorrow's World Economic Outlook press conference, the global economic recovery is proceeding, although more robustly in emerging economies than in advanced countries. This should help underpin improvements in households and bank balance sheets. Indeed, U.S. and European banking systems have strengthened their capital ratios to over 10 percent on average, and our barometer of crisis related losses since 2007 shows that all but 550 billion dollars of the total estimated of 2.2 trillion dollars has been realized. So, three quarters of these losses have already been provisioned. Finally, the forceful measures taken by European policy makers have reduced tail risks and funding strains.

The bad news, however, is that despite this progress, confidence is not yet fully back. This explains why financial markets remain sensitive to “negative surprises” and can so quickly shift back to “crisis mode”. What is at the heart of this lack of confidence? Basically, two things. First, vulnerabilities in financial systems, and second weaknesses in sovereign balance sheets.

As regards the first, the process of bank balance sheet repair and reform remains unfinished business. And financial systems in many countries are still vulnerable to funding disruptions that could endanger the economic recovery and weaken government budget. These vulnerabilities are more pronounced in the euro area. Banks there have a lot of debt to refinance because of their heavy reliance on wholesale funding, a large portion of which matures in the next two years. For certain banks, their sovereign exposures, legacy asset problems, as well as weak business models leave their funding highly sensitive to confidence shocks and increase the size of the capital buffers that they need to ensure open access to funding markets. In the United States, in turn, concerns about household balance sheets and real estate markets continue to cloud the outlook for loan quality in the banking sector.

The second vulnerability has to do with the fact that weak sovereign balance sheets and large public debt burdens exacerbate financial sector fragilities. This reflects exposure of national financial systems to sovereign debt and limited scope left for budgetary support of the economic recovery and financial stability. Encouragingly, governments have begun to develop, and in some cases implement, plans for medium-term fiscal consolidation. However, sovereign debt is expected to remain at unprecedented levels for many years, and highly exposed to adverse growth shocks. These medium-term debt sustainability concerns can telescope into short-term sovereign funding difficulties and sharply higher funding costs, especially as many advanced economy governments have sizable rollover needs on top of large deficits.

The recent experience in Europe illustrates the danger that these weaknesses in both sovereign and financial balance sheets, if not addressed, could easily reignite deleveraging pressures and cause highly damaging cross-border spillovers.

Let me now turn to policies and explain what are our policy priorities. To fully restore confidence and remain firmly on track toward building financial system resilience, I see the need to act on five fronts:

First, sovereign balance sheets need to be strengthened through credible medium term fiscal consolidation strategies. This should take into account country-specific circumstances and be accompanied where necessary by growth-enhancing structural reforms. Contingent liabilities must be managed and reduced in the medium term, including by ensuring that significant public or private financial enterprises do not enjoy implicit taxpayer support.

Second, legacy problems in the banking system need to be addressed and capital buffers strengthened. A key message of the GFSR is that capital buffers for some European banks should be increased to reduce vulnerabilities, to renew funding stress, and to protect against downside risks. Moreover, in some countries, both inside and outside of Europe, weaker financial institutions still need to be restructured or resolved to ensure the viability of the resulting financial industry.

Third, exits from extraordinary policy support need to be carefully considered. Given the risks to the outlook, central banks and governments should remain open to providing financial support, if and when needed, and make their exit strategies contingent on adequate progress on the stability front. The sooner the financial system stabilizes, the sooner these public support measures can be unwound.

Fourth, further progress on regulatory reform is needed to prevent future crises. We welcome the Basel committee's announcements which entail a substantial improvement in bank capital and liquidity standards. But, more needs to be done in other fronts of the broad financial reform agenda, including going beyond banks. In this respect, it is particularly important to address systemic risks related to procyclicality and to “too-important-to-fail” financial institutions. This should be done through adequate regulation, enhanced supervision and the establishment of effective resolution regimes for failing financial firms, both nationally and across borders. Market discipline needs to be brought back.

And fifth, many emerging market policy makers need to cope with the macro-financial challenges coming from sizable and potentially volatile capital inflows. Targeted use of prudential tools can help reduce pressures on credit markets, in combination with flexible use of market or economic policies. But, measures should also focus on the continued development of local financial markets, and the reinforcement of regulation and supervisory frameworks to enhance the absorptive capacity of local financial systems, and to safely and efficiently intermediate structurally higher capital flows.

To conclude, three years into the crisis, the financial system remains, as I said at the beginning, the Achilles' heel of the economic recovery. We thus need to continue financial sector repair and reform in order to keep the economic recovery firmly on track. Action at the national, and collaboration at the global level, are necessary to achieve this goal. Thank you very much. Now my colleagues and I would be happy to answer any questions you have.

Question: My question is about, how do you assess the risk of asset price bubbles in emerging markets? I have seen some econometric exercises here, but I can't tell how do you assess this risk? And, what is the role of capital controls on these flows.

Mr. Viñals: As concerns the risks of asset bubbles, this is something we have examined even more explicitly in the last GFSR, and our conclusions remain unchanged, that we do not see a risk of generalized asset bubbles in the emerging markets at large, but we can see certain hot spots that require close monitoring, and in some cases policy action. In fact, some of the measures that have been taken in the prudential side by a number of emerging markets over the past few months have succeeded in cooling down some of these tensions, particularly in Asia in real estate markets.

Concerning the role of capital controls, we at the Fund have emphasized always that capital controls remain part of the toolkit at the disposal of national authorities. But, of course, that they cannot be a substitute for a full macroeconomic and macroprudential measures. So, they can be a complement, if necessary, and they should be used judiciously, and bearing in mind that their effectiveness may diminish with the passage of time.

Question: Based on what you say about European banks in the report, I was wondering, there seems to be more work and more funding risks for European banks, do you think that the stress tests realized in Europe were not stringent enough to bring up the recapitalization needs that are in Europe.

Mr. Viñals: In the report, we envisage that funding is perhaps the major challenge confronting banks at present, everywhere. But, those challenges are more pronounced in Europe as a result of the fact that European banks rely relatively more on wholesale funding. I think that about 40 percent of the bank liabilities are in terms of wholesale funding, and because even in the crisis most banks could only issue short-term debt because markets would not accept anything longer. Now, this debt is going to mature. About 4 trillion dollars of debt, globally, are going to mature over the next 24 months. Part of this debt is with European banks, and this is why it makes it particularly important in Europe.

Now, what that means is that banks in Europe should do enough to make markets confident that they're worth lending to these banks. And, I think that the stress tests conducted by the authorities in Europe were tests directed at solvency. They did a very important job in providing a degree of transparency which was missing before, and these were tests that addressed the question of solvency. What we're saying is that beyond that, in those cases, where banks need additional measures to improve their standing, like restructuring, like having higher capital buffers in order to have a better situation, in order to assure continued funding, that this should go on.

Question: Just a quick follow-up on what you just said. Of this 4 trillion of debt that is going to mature, what percentage is from European banks?

Mr. Dattels: Close to three quarters. As Jose mentioned, the reliance of European banks on wholesale funding to total liabilities is roughly 40 percent. This compares to about 20 percent for U.S. banks, U.K. banks, and Japanese banks. In part, this owes to large-sized balance sheets, and the difference between Europe and the U.S. is that Europe does not have the government sponsored enterprises to absorb quite a bit of that mortgage financing.

Not only do they rely more heavily on wholesale funding, but also on cross-border funding in dollars. As we know, this was a source of pressure that was exerted on European banks, when funding in dollars in short-term U.S. money markets dried up. It boils down to confidence and the need for higher capital buffers to ensure confidence of creditors to support bank funding.

Question: I know you have to some extent already gone over this, but could you explain a little more explicitly the unsustainability of sovereign debt in Europe, particularly rollover? Are you politely and diplomatically trying to say that this debt rollover will not be possible without some sort of extraordinary outside funding? Secondly, you discuss the feedback loop of the problems of lower growth, meaning lower revenues, exacerbating confidence in the markets, and raising bond yields. Is that the fiscal, any of the fiscal consolidation plans that you see in Europe, or even the entire thing concerning you in terms of growth? Yesterday, the Institute of International Finance said lack of coordination on that consolidation could be too much of a constraint.

Mr. Viñals: We are not saying at all in the report that public debt is unsustainable in any European country. What we're saying is that public debt is very high. In many cases is unprecedentedly high, and therefore that it needs to be addressed through forceful, credible, medium-term fiscal consolidation strategies. In the countries which are more subject to market pressure, these fiscal consolidation efforts are taking place already, and the authorities, which are subject to the greatest challenge, like in the case of Ireland, or Portugal more recently, are publicly coming out with announcements that basically reinforce the strong commitment that they have to fiscal consolidation. So, we think that these national measures certainly go in the right direction, and that perseverance with fiscal adjustment in these countries is fundamental to avoid future outcomes. So, for the time being, I think that this is what is most important.

Of course, if these measures were to falter, then you would have sovereign risk going up, and spilling over to the financial system. We know that this can set in place very adverse public and private debt dynamics, and that is to be avoided. This is why one of the top policy priorities that I have mentioned is the pursuit of credible medium-term fiscal consolidation strategies. Now, I think that internationally, different countries are in different situations, so that the timing of these plans depends on national circumstances. Of course, it is those countries which are subject to market pressures, those who have to do more and more immediately. Thank you.

Question: I know that in the last conference of April, you had discussed about a tax on the banks in order to create a fund for supporting the banks, the global banks, which maybe could have problems with their money. Would you be able to discuss that idea again now?

Mr. Viñals: As you mention, the Fund put forward in June to the G-20 a report which had been mandated by the G-20, on what we call a financial sector contribution linked to paying for the cost of resolving future failures in financial institutions. So, these resolution funds are not to keep institutions alive, but to give them a decent burial. That proposal was on the table. That proposal is being discussed at the national and regional level, in different countries, some are willing to go forward with a variant of this proposal, some or not. But, the issue of the financial sector contribution is one which still remains on the table among the menu of options that can be used in order to facilitate the resolution of failing financial institutions.

Question: On the Chinese local government financing platforms, instead of the banks, do you see local governments solvency being a problem in the near or medium term? Also, in July in the Article IV assessment, you are recommending local governments issuing bonds. Do you think this is the time for local Chinese local governments to go on that path?

Mr. Viñals: Let me answer your question on the local government financial platforms. This is a vehicle that has been used quite a lot in China in order to provide financing for local projects. A lot of this money has gone into infrastructure spending. I think that from the financial stability side, what we look at is, what should be important also for the Chinese authorities, is to what extent is there enough quality in these loans, and to what extent is there enough transparency in the granting of these loans? I think the Chinese authorities are already taking measures in order to introduce transparency, and to strengthen the oversight of these platforms so that the risks associated with the quality of the loans and the market value of the infrastructure which is being financed by these loans, and in many cases is the collateral for these loans, that there are no financial stability risks there. I think this is an issue which we flag in the report. We have a specific box devoted to these things. And this is something which is already on the radar screen of the Chinese authorities, and we think this is a very sound policy to pursue on their part.

Mr. Murray: I will turn to the Media Briefing Center. A question from The Wall Street Journal. Question, how does volatility in the currency markets affect the outlook for financial stability and the strength of the financial systems?

Mr. Viñals: Volatility in currency markets has always been there. Asset markets, exchange rates are volatile by nature. The important thing is that markets do not go into episodes of excess volatility or turbulence.

We think that this is a new issue. And, we think that the best way of protecting against any unintended consequences of foreign exchange rate changes on financial balance sheets is to have sound buffers to accommodate whatever changes happen. For the time being, we think this is something which is not a major concern for financial stability, but what I think is even more important is that internationally, exchange rate changes in line with medium-term fundamentals is something which is very important for the international rebalancing that is needed, external demand must come from countries with surpluses, countries with deficits must export more to countries with surpluses. And, exchange rates have to play a role. So we think that changes in exchange rates that go in the direction of medium-term fundamentals are certainly not a problem for financial stability, and it is something that the world needs in order to achieve a more balanced global growth.

Question: I didn't hear you mention at all your assessment of frontier markets and the developing economies, and yet what we saw when the financial crisis set in is that despite the initial thinking, it was not going to affect frontier markets, and developing economies. They ended up suffering most from the second-round effects of the financial crisis. What is the outlook for developing economies and frontier markets?

Mr. Dattels: First, in terms of the outlook, the broader global growth picture in emerging markets is very much a positive one, and that also includes the outlook for commodity prices. So, from the real economy perspective, the outlook is a favorable one for frontier economies. In terms of financial vulnerabilities, frontier markets are moving into the limelight along with other emerging markets as a destination for foreign investor flows. One of the themes that we have in the GFSR is that the improved, relatively better fundamentals in emerging markets, along with improving fundamentals in frontier markets, including growth prospects, debt levels, this is likely to engender a further structural shift in asset allocation toward emerging markets.

We have some analysis in the report that would suggest that with that type of a flow, you could see substantial amounts of funding move in to emerging markets. That represents a challenge for frontier markets, as well, as emerging markets. I think some of the fundamental factors needed that Jose has been outlining for intermediating those flows and ensuring that local institutions are sufficiently well capitalized, well supervised to manage those inflows, and a solid macroprudential framework will help ensure that you don't have credit-led bubbles being created, and so that credit can be channeled to the most productive sources. With frontier markets, the major difference is those flows are more likely to be channeled through financial institutions, less so in financial markets. So, I think the focus is clearly ensuring financial institutions are sound.

Question: I just wanted some quick guidance on Table 1.1 on page 6, the sovereign market and vulnerability indicators. I figure this is meant to be read as a composite, but if you had to prioritize the difference columns there, which do you think is the most severe sign of vulnerability, would it be overall financing needs, reliance on external fanned, large primary balance, which ones are the most important, if you had to rank them?

Mr. Brockmeijer: I don't think we would go into the process of ranking these. The strength of these tables is it gives you an overview, many aspects in assessing the vulnerabilities. The intent of this table is to provide a broad overview of those aspects. So, we're exactly trying to avoid people zooming in on one little figure and saying this is good or bad. It is the broader picture we're trying to convey. Sorry I didn't answer your question with a precise number.

Mr. Dattels: Just to say, the beauty of the table is that you can move horizontally, so that you can see what countries share a multiple of vulnerabilities, including, for example, high deficit levels, high debt stock levels, high reliance on external funding, and say low ratings. So you can look at that table horizontally as well as vertically, by category, as Jan indicated.

Question: Do you think the economic downturn in emerging markets could have been mitigated with a larger financial inclusion of the population? Do you think the economic recovery in those countries could be accelerated with further and more effectively serving the unbanked population in emerging markets?

Mr. Viñals: I think the issue of financial inclusion is a very important issue. Certainly, this is something that can be extremely important for a number of developing countries, even in some emerging markets. We think this is certainly worth pursuing. Extending the banking system services, at the very basic level, to larger parts of the population, is something that is also worthwhile. What is very important, too, is that the population has the financial education which is necessary in order to make good use of these banking and financial services that they will have access to in the future.

Question: The report mentions specifically Landesbanken and Spanish cajas as a source of problems in the European financial sector. Are the German government and the Spanish government doing enough?

Mr. Viñals: What we say about the Landesbanken and the cajas is that these are two segments of national banking systems in Europe where the restructuring process needs to advance. I think that the good news is that it is advancing: In Spain, the authorities have taken very seriously the task of restructuring the cajas. This is something which has already started, and it is important that the process is continued to its ultimate consequences. And, in the case of Germany, again, there is action on the part of the national authorities to deal with a Landesbanken and to consolidate. So, I think that the important thing is to go ahead, and to follow through with determination in order to resolve and restructure. Resolve those financial institutions which are weak and nonviable, and restructure those financial institutions which are weak, but viable. Because, what you really want to leave is a core financial institution which has sufficient muscle to support the recovery, and not leave any zombie banks which could be a drag on the recovery.

Question: What is the assessment of the IMF of how much time it will take to return things to the normal? What is your assessment? And, how is it impacting the developing economies?

Mr. Viñals: How much time it takes to return things to normal depends very much on the decisiveness of the policy actions taken. As we have emphasized, the fact that the financial system remains the soft spot, the Achilles' heel of the economic recovery, means that there is still financial repair and reform to be done. And that means addressing the problem of weaker banks, banks that are not regarded as strong enough, by giving them enough buffers. But at the same time, I think that the actions at the national level need to be complemented by coordinated collaborative actions at the global level, to set in place a regulatory reform process that makes everybody see that we are going to a safe financial system. From this viewpoint, I think that the important progress that has been made on the bank reform, through the Basle III package, needs to be now complemented by progress on other fronts of the reform agenda that go beyond banks to tackle systemic risk. And, for that matter, I think that the political support is needed to foster the G-20 process, and have enough impetus so that there is no loss of moment and we can provide sufficient clarity concerning where we are going. The political leadership of this process is under the G-20. The coordinating function is for the Financial Stability Board. The standard setting work is being done by the standard setters. Of course, the Fund is also contributing to this process. It is fundamental that we get political support behind those movements to really put a safer regulation in place, to really make the financial system safer. The sooner we can do that, the better.

Question: I may have missed this, but my quick question is, if Ireland and Greece gets worse, how can this affect emerging markets in Asia? And, especially for Indonesia, how prone is this country to the situation? What areas in the financial sector need to improve?

Mr. Viñals: First of all, I think that what we hope is that Greece and Ireland will get better and not worse. In fact, in the case of Greece, the authorities are forcefully pursuing the program of fiscal consolidation and structural reforms. So, this is something that should help underpin confidence in sovereign debt markets. And, at the same time, in Ireland, what we're seeing is that the authorities are taking very decisive actions concerning the necessary reforms in the financial system to address well known bank problems, and at the same time they are committed to continuing with the fiscal consolidation program. So, I think that my expectation would be for things to get better, not for things to get worse.

But, in any case, as I mentioned during my presentation, I think it is important that emerging markets be prepared to handle not only high inflows coming from advanced economies, but also prepare for the risks of future outflows and for that you need to have a resilient financial sector where you have banks and other local capital markets being robust to withstand these ins and outs. I think this is the best way to prepare. And, talking of the case of Indonesia in particular, that would be one of the countries where the authorities have taken recently macroprudential or prudential measures in order to preserve financial stability in the context of high foreign capital inflows.

Question: It seems that the countries all over the world, basically in Europe, have to make a delicate balancing act in order to resolve the fiscal and financial problems, looking forward to restore confidence of the markets. But, along with this, there are huge concerns about growth that complicate this balancing act. So, in your point of view, what are the markets looking for first, and which will be the answer, from the country should be?

Mr. Viñals: I think that it is true that you have to reconcile several goals when you make policy. But, I think that for those countries which are more under market pressure, in Europe, insofar as this pressure comes from sovereign risk, and concerns about the path of debt going forward, and debt sustainability, it is of the essence that these countries persevere in the fiscal consolidation strategies that they have announced, and in those cases where they deem it necessary, that they go even further. So, I think that this is fundamental. Of course, on the financial side, it is also very important that if the risks to the economic outlook remain elevated, particularly on the financial side, that the central banks and the other national authorities continue providing support for the local financial systems. Although, this support will vary, depending on the intensity of the country's problems, and would also be conditioned with available room for maneuver that there is, for example in terms of the public finances. So, I agree that this is a delicate balancing act. This is the art of economic policy making: Trying to make the best under very difficult economic circumstances. But, what we hope is that if these countries continue in the path that they have embarked upon, that they will make things get better over time.

Mr. Murray: We have received a number of questions via the Media Briefing Center that are not germane to this press conference, so we will get back to you bilaterally or in some other fashion. For instance, a question about Pakistan, and additional actions necessary because of the devastating floods there. We'll get back to you on that. I'm going to wrap up with one last question, this gentleman here has been raising his hand repeatedly and then I'll thank everybody for joining us today.

Question: The Brazilian government raised the tax on foreign capital investors in bonds. The decision was announced yesterday. The tax was raised from 2 percent to 4 percent. According to your analysis, the previous movement of the tax of 2 percent was not very effective. Would you have a comment on that?

Mr. Viñals: I think that as I said, capital controls and prudential measures are certainly part of the toolkit of countries, and actions to restrain capital inflows may be more effective under certain circumstances than others. In the case of Brazil, what we saw is that the application of the 2 percent tax recently had an effect in terms of changing the composition of the flows, but had less of an impact on the total inflows coming. But, of course, one cannot say that the 4 percent increase will not be effective in achieving these goals. I think that the 2 percent that was imposed was more effective in certain areas than others, and 4 percent may be a different ballgame, particularly because it goes to put more of a tax on those flows, bonds, which before proved more resilient to the previous tax, which was imposed, if I remember correctly, on equity and bond flows. Last time, equity flows moderated, but bond flows remained. Now, increasing the tax on bonds specifically to see if this will come down. So, I think the jury is still out and we just have to see what happens to assess the effectiveness of this new measure.

Mr. Murray: Thank you, José. Thanks to everybody for joining us here and on line. If you have any follow-up questions, send an e-mail to media@imf.org. Thank you, Mr. Viñals, Mr. Brockmeijer, Mr. Sheehy, and Mr. Dattels.